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Investing legend: ‘Higher valuations are here to stay’

“Grantham says higher valuations here to stay,” ran a headline in the June 2 Financial Times. The reference is to Jeremy Grantham, oracle of mean reversion, anatomist of asset-price bubbles, prophet of climate change, and the “G” in the Boston money-management firm GMO, LLC.

Grantham has changed his mind. The question before the house is whether we should change ours, too.

Many investors, especially members of the value tribe, are wobbling. Rich markets remain highly valued. High profit margins remain elevated. Poor gross domestic product (GDP) growth, worse demographics, and weak productivity seem not to count as they might (or should) on the scales of investment success.

Hedge funds shut down, exchange-traded funds prosper, and security analysis disappoints. It seems a waste of time to pore through Securities and Exchange Commission (SEC) filings when investors insist on buying “exposure” rather than individual stocks and bonds. Even when the stock market does take a tumble, it doesn’t stay low for long (as it did, for instance, from 1973 to 1987 and, before that, between 1930 and 1956). To Grantham, it looks like a new era. What it does not look like is a bubble.

Since 1997, the famous bear noted in his first-quarter letter, profit margins in American companies have averaged 30% higher than in the preceding 70 years. Price-to-earnings ratios, too, have seemingly come to rest on some permanent high plateau. What kind of capitalism is this?

“A dedicated value investor like me eats, breathes and dreams mean reversion,” the Financial Times article quotes Grantham as saying. “It’s very hard to see when the world has changed. But my job description is to think about markets and not to be a member of a cult.”

Spare us all from cults, even – this is a little close to home – the cult of skepticism. Still, by Grantham’s own telling, the world isn’t about to change. It’s already changed – started changing 20 years ago, in fact.

Nor has the shift exactly gone unnoticed. Higher free cash flow, shrunken capital outlays, massive share repurchases, and miniscule interest rates have pushed stock prices to an average that’s 64% higher than the average of the past hundred years, he points out. It’s no bubble, the renowned bubble-ologist insists, rather, a phase of financial evolution.

Before venturing a guess on the staying power of these prices, valuations, and profit margins, a few more words from Grantham are in order. Among the sources of the supposed new era, he has identified these: aging populations, extreme income inequality, slow economic growth, radical monetary policy, and – the crux of the matter – persistently high corporate profits.

“I used to call profit margins the most dependably mean-reverting series in finance,” Grantham writes. “And they were through 1997. So why did they stop mean reverting around the old trend?”

Among the reasons proposed: the rising value of corporate brands, a trend enhanced by more and more globalization; “steadily increasing corporate power”; and lower real interest rates with higher corporate leverage. As to this final item, “Pre-1997 real rates averaged 200 basis points higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average, leaving them a mere 6% higher.”

Yet, Grantham reasons, in a well-tempered enterprise system, above-trend margins could not have persisted. Competition would have flattened them, whatever the cost of borrowing or the level of corporate indebtedness. But margins remain unflattened, “and I believe it was precisely these other factors – increased monopoly, political, and brand power – that had created this new stickiness in profits that allowed these new higher margin levels to be sustained for so long.”

To repeat, Grantham’s observations are historical. He is guessing about the future, just like the rest of us. If you watch his televised interview with James Mackintosh on the Wall Street Journal‘s website, you’ll see that the old bear isn’t even bullish (he says that he might do some buying in case of a 20% pullback). Then is this time really different? “This time,” said Grantham, “is decently different.”

Decently different in the technological respect, we would say. Radically different in the monetary dimension. The world has had 200 years of experience with innovation, disruption, and creative destruction, dating back at least to the displacement of English weavers by the bloody, job-killing, wealth-creating, and humanity-enhancing mechanical loom. The world has had no experience with the consequences of unprecedented monetary action. How could it have?

And because there’s no predicting the outcome of a first-in-5,000-years experiment in negative nominal bond yields, zero-percent funding costs, and multitrillion-dollar credit creation, we are not so quick as our friend from Boston to accept that this unique constellation of deformities will sustain the stock market in the high style to which it’s become accustomed.

Technological disruption seems a strange accompaniment to an alleged new age of elevated corporate profitability. Established business models are no sturdier on account of digital disruption. They rather seem more vulnerable. Hoteliers, cab companies, money managers, grocery chains, oil companies, newspaper publishers, network TV stations, ad agencies, shopping-mall owners, telecommunications providers, to name a few, can only wish that they lived in a time of permanently elevated margins…

Regards,

Jim Grant

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